Startup finance guide: Capitalization (cap) tables

Funding your SMB can involve multiple rounds of investment, with different partners acquiring varying ownership stakes. And keeping track of this complex structure can be a challenge. That is where a capitalization table comes in.

A capitalization, or “cap” table acts as a central document outlining your company's ownership breakdown, detailing who owns what share and how much they’re worth. 

In this blog, we'll explore the intricacies of cap tables, from their benefits to their drawbacks, and how you can create one for your business.

Key highlights: 

• A capitalization table helps you analyze equity ownership, the amount of capital raised, and more.
• Creating a cap table is a collaborative effort. All the major stakeholders need to share information to get a clear picture that represents facts.
• Maintaining a precise and up-to-date cap table helps accurately track ownership, make strategic decisions, and meet legal obligations.

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What is a capitalization table?

A cap table is a spreadsheet that details a company's ownership. It lists the total number of shares and who owns them. While cap tables are most commonly used by startups and early-stage businesses, any company can use them. 

Essentially, it provides a clear breakdown of all the shareholders and their equity in the company.

What information does the cap table keep track of?

Cap tables list all types of ownership in the company. This includes common shares, preferred shares, warrants, convertible equity, and other types of investment instruments. 

Here’s a breakdown of the most common types:

• Common shares: Typically owned by founders and employees
• Preferred shares: Held by investors
• Warrants: Give the right to buy shares in the future
• Convertible equity: These can turn into shares later on. 

It’s worth nothing since cap tables contain sensitive information about a company's ownership and equity distribution, they are not public documents. Startups usually keep their cap tables confidential to protect their competitive edge and the privacy of their shareholders.

What is ownership dilution?

Ownership dilution happens when a company issues new shares, reducing the ownership percentage of existing shareholders. This can occur during fundraising, when stock options are used, or when convertible securities are turned into shares. 

Even though existing shareholders still have the same number of shares, their share of the total company decreases because the overall number of shares has increased.

For example, if you own 100 shares in a company with 1,000 shares in total, you own 10% of the company. If the company issues 1,000 more shares, making the total 2,000 shares, your 100 shares now represent only 5% of the company.

Who contributes to the cap table?

Several key parties contribute to the cap table, each playing an important role in showing who owns parts of the company:

1. Founders: They are the original owners of the company and usually hold common shares.
2. Investors: These are people or organizations that invest money into the company in exchange for equity, often getting preferred shares.
3. Employees: They might receive stock options or shares as part of their pay to motivate and reward them.
4. Advisors: These individuals provide valuable advice and expertise and sometimes get equity as compensation.
5. Board members: They help guide the company and may be given shares or options as part of their compensation.
6. Convertible security holders: These are people who hold convertible notes or similar securities that can later be turned into shares.
7. Lawyers and accountants: These professionals assist in structuring the equity and making sure everything follows legal and financial rules. They also help keep the cap table up to date.

All these contributors provide the necessary information to create a complete and clear picture of the company's ownership structure.

Why do startups need cap tables?

For startups, cap tables are essential because they help founders and investors understand ownership, plan their growth, and stay organized. 

Now, let’s take a closer look at why capitalization tables are beneficial for the parties involved in a startup: founders and investors. 

For founders

• Run the company better: A cap table helps founders understand who owns parts of the company, and how much they own. This is important for the growth and management of the company.
• Manage the employee stock option pool: Startups often compensate employees with equity. The cap table keeps track of these shares and helps make sure they're managed correctly.

For investors

• Informs how much to invest: Investors use a cap table to see who owns how much of the company and how much the company is worth. This helps them decide how much money they should invest and how valuable their investment could be.
• Helps calculate future dilution: The cap table helps investors see what might happen if the company gets more money or gives out more ownership. 
• Reveals other investors: Investors also use the cap table to see who else is investing in the company, including their commitment levels to the business.

Understanding the cap table

Entrepreneurs, investors, and other stakeholders can learn a lot about a company by looking at its cap table and understanding it. It tells the story of who's involved and how everything fits together financially. 

Let’s get familiar with the components of a cap table:

1. Common stock: This is the most basic type of share in a company. If you own common stock, you can vote on decisions like choosing company leaders and receiving dividends when the company makes a profit. 

2. Preferred stock: Preferred stockholders get special benefits compared to common stockholders. They usually receive dividends before common stockholders and have priority in getting their money back if the company shuts down and sells its assets. They may also convert their shares into common stock.

3. Stock options: These are rewards given to employees, directors, or consultants. They allow them to buy company shares at a set price within a specific timeframe. Typically, stock option holders take ownership of their stock after a specific time period, called a “vesting period.”

4. Warrants: Similar to stock options, warrants are given to outside investors like venture capitalists. They allow holders to buy a specific number of shares at a fixed price for a certain period. Warrants can affect ownership and dilute existing shareholders.

5. Convertible notes: These are loans that can be converted into company stock later, often during the next investment round. They have a maturity date (when they must be paid back), an interest rate, and a conversion price. They give investors flexibility by letting them turn their debt into ownership if the company does well.

6. SAFEs (Simple Agreements for Future Equity): SAFEs are a newer way for startups to raise money without setting a specific value for the company. Investors agree to invest now and get shares later, usually when the company raises more money in the future. This simplifies the investment process and shows potential future ownership changes on the cap table.

Waterfall analysis

Waterfall analysis refers to a method used to predict how proceeds from a liquidity event (a sale or exit) would be distributed among shareholders based on their priority or preference. It helps predict who gets paid first (and how much) if the company is sold.

For example, preferred shareholders might get paid back first before common shareholders. 

A waterfall analysis helps everyone see and understand how the money from a big company event would be shared among the owners, based on the rules set out in the cap table.

How to create and maintain a cap table

Creating and maintaining a cap table is essential for any company to track ownership and equity distribution accurately. 

Tools: Excel vs. equity management platform

When managing a cap table, you have the option of using tools like Excel or specialized equity management platforms for meticulous record-keeping and updating.

1. Excel: Using Excel is cost-effective and straightforward for smaller companies or startups with simpler cap table structures. It allows for customization and can handle basic calculations and scenarios.

2. Equity management platform: As your company grows or after complex transactions like an ESOP or funding round, dedicated equity management platforms offer automation, integration with financial data, and compliance features. These platforms provide real-time updates and scenario modeling.

Special considerations

Companies are always changing, so their cap tables need ongoing updates. Startups raise multiple funding rounds to secure capital and offer stock options to attract skilled employees, both of which impact the cap table. 

Additionally, changes occur when options are terminated upon an employee's departure, allowed to expire, or when investors exercise their vested options, redeem, transfer, or sell shares.

Good cap table governance

Good cap table governance involves keeping detailed records and updating them regularly to ensure accuracy and transparency in who owns company equity. It's crucial to document board decisions, offer letters, and employment dates for vesting. 

Also, make sure to keep signed agreements for options and consultants, especially if they involve equity.

To follow best practices, update the cap table as soon as there's a change in ownership, and date each update for clarity. It's wise to share responsibility for managing the cap table with your legal counsel – this helps maintain oversight and ensures compliance with rules, building trust among stakeholders and supporting smart decision-making.

What is a pro forma cap table?

A pro forma cap table is a tool that helps investors and entrepreneurs see how ownership in a business will look after an investment round or other changes in equity. It shows the current ownership and predicts what it will look like after the fundraising event.

The pro forma cap table gives a detailed view of who owns how many shares, what percentage of the company each shareholder will have, and the value of each share. 

This information is important for investors, entrepreneurs, and anyone interested in understanding how the company's ownership is structured, who owns what, and how much each owner holds.

Using the cap table for scenario analysis

Let’s say you want to analyze the potential impact of different events and uncertainties on your company. That’s known as a scenario analysis. It uses the data from the cap table to project future outcomes. 

To run a scenario analysis from your cap table, you have to first identify potential events. Scenarios include (but are not limited to):

• New funding rounds
• Issuing more employee stock options
• A merger
• An IPO
• Exit scenarios

Then, you’ll have to adjust the cap table to reflect each scenario, calculating the ownership percentages for all stakeholders. 

Capitalization table examples

Let’s look at a few examples of cap tables to get a better practical knowledge of how to create them:

Simple cap table example

This example illustrates a basic cap table structure using two main sections: valuation and ownership.

Valuation section: Enter two key pieces of information:

1. Current company value (e.g., $1 million)
2. Current number of shares outstanding (e.g., 200,000)

Ownership section: Input the dollar value each investor contributes to the funding round:

• Investor 1: $100,000
• Investor 2: $250,000
• Additional investors: Enter as needed

This simple structure allows for quick visualization of company valuation and ownership distribution after a funding round. It serves as a starting point for more complex cap table models as the company grows and undergoes additional financing events.

Startup cap table calculation example

This example demonstrates how to update a cap table when a new investor joins, ensuring the total ownership remains at 100%. We'll walk through the process step-by-step:

Initial scenario:

• Company has 100,000 outstanding shares
• Founder owns 50% (50,000 shares)
• Angel investor owns 50% (50,000 shares)

New investment:

• VC invests $1 million for 10% ownership
• Company valuation: $10 million

Calculation process:

New Shares = [Ownership Stake ÷ (1 - Ownership Stake)] × Old Shares]

= [0.10 ÷ (1 - 0.10)] × 100,000] = 11,111

Verification: VC's ownership = 11,111 ÷ (100,000 + 11,111) = 10%

VC cap table modeling example

This example illustrates how proceeds from a liquidity event are distributed among shareholders based on their ownership and preferences.

Initial scenario:

• Founder: 45.05%
• Angel Investor: 45.05%
• VC (Series A): 10% (with 1x non-participating liquidation preference)

Now, let’s assume that company sells for $100M (above the initial valuation)

VC's options:

1. Take preference: $1 million
2. Convert to common: 10% of $100M = $10M

Decision: VC converts to common

Distribution:

• VC: $10M (10%)
• Founder: $45M (45.05%)
• Angel Investor: $45M (45.05%)

Increasing complexity among cap tables: a discussion

As startups progress through multiple funding rounds and organizational changes, their cap tables evolve to reflect various financial instruments and stakeholder arrangements. 

Here's a look at the key factors contributing to increasing complexity in cap tables:

• Different investor rights and privileges: Investors may receive varying terms, even within the same investment vehicle. This can include different liquidation preferences, anti-dilution provisions, or discount rates, all of which must be accurately reflected in the cap table.
• Convertible debt in bridge or follow-on rounds: Startups may use convertible debt for interim financing. The conversion price is often unknown until the next equity round, complicating ownership projections and requiring careful tracking in the cap table.
• Anti-dilution protection activation: In a down round (funding at a lower valuation), previous investors' anti-dilution provisions may trigger. This adjusts their stake to compensate for the dilution, adding complexity to ownership calculations.
• Stock option and warrant activity: Employees exercising options become direct shareholders while departing employees with invested options lead to changes in potential ownership structure. Cap table updates are necessary here.
• Expansion of employee share option pools: Growing companies often increase their option pool to attract talent. New hires may receive options at different strike prices, adding layers to the cap table and requiring detailed record-keeping.

Excel-based cap tables: a discussion

While Excel has long been a go-to tool for creating and managing cap tables, it comes with both advantages and drawbacks. Let's examine the key benefits and challenges of using Excel-based cap tables:

Benefits

• Flexibility and customization: Excel allows users to tailor cap tables to their specific needs, easily adding new columns or calculations as required. This adaptability is particularly useful for startups with unique ownership structures or specific reporting requirements.
• Low cost and accessibility: Most businesses already have access to Excel, eliminating the need for additional software costs or subscriptions. This makes it an attractive option for cash-conscious startups and small businesses managing their finances.
• Familiarity: Many finance professionals and entrepreneurs are already proficient in Excel, reducing the learning curve for basic cap table creation and management. This familiarity can lead to quicker implementation and easier adoption within the team.

Challenges

• Version control: Excel files can easily proliferate, leading to multiple versions and potential inconsistencies. This makes it challenging to ensure all stakeholders are working with the most up-to-date and accurate information.
• Limited collaboration features: Sharing and simultaneous editing of Excel files can be cumbersome, especially as the number of stakeholders grows. Version control becomes increasingly difficult, potentially leading to confusion and errors.
• Prone to human error: Manual data entry and formula creation in Excel increase the risk of mistakes. Complex calculations can be challenging to verify and audit, potentially leading to inaccuracies in ownership percentages or financial projections.

FAQs about capitalization tables

What do investors look for in a cap table?

Investors look for clarity and accuracy in a cap table, ensuring it reflects the ownership structure, including shares, options, and convertible securities. They want to see the equity distribution among founders, employees, and other investors to assess potential returns and control dynamics.

What is the difference between a cap table and a term sheet?

A cap table is a detailed document showing the ownership stakes in a company, including shares, options, and warrants. In contrast, a term sheet outlines the terms and conditions of an investment, including valuation, investor rights, and deal structure.

Who prepares a cap table?

The preparation of a cap table is typically handled by the company's founders, often with assistance from their legal and financial advisors. It is crucial for maintaining accurate records of equity distribution and changes over time.

Should employees see the cap table?

Employees should generally have access to a simplified version of the cap table that shows their own equity and options. Full transparency of the entire cap table is usually restricted to senior management and key stakeholders to protect sensitive information.

What is an example of a cap table?

An example of a cap table would include columns for shareholder names, the number of shares owned, the percentage of total ownership, and any options or warrants held. This table helps in visualizing the equity distribution and calculating dilution during fundraising rounds.

What is the purpose of the cap table?

The purpose of the cap table is to provide a clear, organized record of a company's equity ownership structure. It is essential for managing equity, understanding ownership percentages, and making informed decisions about financing and dilution.

What is the difference between a cap table and a stock ledger?

A capitalization table details the ownership structure, including shares, options, and other equity instruments, showing who owns what percentage of the company. A stock ledger, however, is a formal record of all stock transactions and is used to track the issuance, transfer, and cancellation of shares.

Conclusion: Good cap table management is key

Capitalization tables are essential tools for SMB finance, providing a clear picture of a company's ownership structure and potential returns in various scenarios.

As businesses grow and attract more investors, these tables become increasingly complex, requiring careful management and regular updates. Also, understanding how to create a cap table for different situations and the pros and cons associated with it can help you make better-informed business decisions.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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